All Party Parliamentary Small Business Group

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1 All Party Parliamentary Small Business Group An Inquiry into Productivity and Small Firms This is not an official publication of the House of Commons or the House of Lords it has not been approved by either House or its committees. All-Party Groups are informal groups of Members of both Houses with a common interest in particular issues. The views expressed in this Report are those of the Group. This Report was researched and funded by the Federation of Small Businesses.

2 Federation of Small federationofsmallbusinesses

3 Contents Productivity Inquiry Commitee 4 Acknowledgments 4 Foreword 5 Introduction 6 The UK s productivity performance: An overview 8 Drivers of small business productivity: Access to finance and business investment 12 Connecting markets: infrastructure and regional development 19 Innovation, technology and clustering policy 28 Skills and the labour market 33 Improving access to business support and new commercial opportunities 42 Conclusion 49 Appendix 1: Witnesses and Written Evidence 51 Appendix 2: Defining Productivity 53 3

4 Productivity inquiry committee Brian Binley MP (Chair) Debbie Abrahams MP Fiona Bruce MP Lord Cotter Simon Danczuk MP Lord Harrison Anne Marie Morris MP David Rutley MP Andrew Stunell MP Acknowledgements We would like to thank all the witnesses who gave oral evidence and the organisations who submitted written evidence. We would also like to extend our gratitude to the staff at the Federation of Small Businesses for their support. 4

5 Foreword Despite increasing UK economic growth, productivity levels continue to lag behind our competitors with UK productivity nearly 20 per cent lower than the average for G7 countries. This is affecting competitiveness, earnings and our potential to generate higher economic growth. The debate on productivity has mainly focused on the macroeconomic causes and solutions. Small businesses are the lifeblood of the UK economy. If we are to improve our productivity levels there needs to be a small business focused solution. During the course of this inquiry we have had the pleasure to hear from a wide variety of different organisations from business groups, the education sector, to Local Enterprise Partnerships (LEPs) and academics. We would like to take this opportunity to thank everyone who submitted evidence to the inquiry, and to the Federation of Small Businesses (FSB) for providing the secretariat. There was one thing we heard across all the evidence we received: we are not sufficiently capitalising on our resources and the Government needs to act to boost productivity levels. We need to rebalance the economy to maximise our output across the country. There is a marked difference in the productivity levels of London and the South East compared to the rest of the country. It needs to be easier for firms to both physically and virtually access customers. We need more investment in productive capital and for infrastructure to be delivered - not just announced by the Government. Broadband has become a vital service for small businesses to compete and grow. The disparity in coverage across the country and particularly in rural areas can be seen as evidence of a digital infrastructure policy that is no more than a work in progress. To enable more of our businesses to compete in global markets, the Government must be far more ambitious than the current targets. It is not just regional differences that are holding back our productivity potential. Across the country the education and skills systems are not delivering the skilled workforce businesses need. It is a travesty that so many young people are leaving schools and universities unprepared for the workplace. We need to address the skills gaps preventing small businesses from growing, aligning businesses and education, embedding employability skills into every school curriculum and encouraging more firms to invest in workforce training. The ability of small businesses to access finance to invest and innovate remains a considerable barrier to growth. Small and start-up businesses also require support and advice to scale up and secure new commercial opportunities, both domestically and in export markets. The current plethora of support schemes makes it difficult for small businesses to navigate and although the Government has made steps to streamline support centrally, it could go further. The present Government has taken a number of positive steps to support small businesses. However, if the UK economy is to remain competitive and deliver sustained and balanced growth in the future we must address the drivers behind our relatively low levels of productivity. Our inquiry has found that there are many areas where a future Government could boost the performance and productivity of small businesses and in turn help more to become world-beating firms. This report sets out a blueprint for the next Government, whatever its colour, to finally address our historic productivity weakness and drive forward our economy in the years to come. Brian Binley MP, Chair of the Productivity Inquiry Anne Marie Morris MP, Chair of the All Party Parliamentary Small Business Group 5

6 Introduction 1. Following the financial crisis, productivity growth has weakened significantly. As the economy moves into recovery, it is essential that productivity levels improve. Even before the crash successive governments have attempted to boost productivity and on most measures it has remained consistently low relative to our key OECD competitors. 2. This suggests that despite a growing economy and evidence of a flourishing of entrepreneurial activity, there remains a structural productivity gap facing the UK. Much of the debate on the UK s poor productivity performance has explored macro economic causes and consequences. Relatively less attention has been paid to what has been happening at an individual business level, and even less within small businesses. 3. In May 2014, the All Party Parliamentary Small Business Group launched a wide-ranging inquiry into drivers of small business productivity. It took evidence from a variety of organisations, including academics, businesses, Government departments, non-governmental bodies and others with expertise in this area. 4. This report presents the main findings from the inquiry. It argues that the Government has a critical role to play in supporting the productivity growth of small businesses, by creating the right environment for businesses to grow and invest and by breaking down barriers to enterprise. This includes improving access to finance, ensuring the tax system encourages productive investment, fostering innovation and technology development, investing in critical infrastructure, creating skills and education systems that meet businesses requirements, and streamlining business support. 5. This inquiry has sought to identify practical solutions to UK s productivity gap and set a challenge for the next Government to finally address this long-standing weakness. Our goal must be to create a business environment that will nurture and support productive enterprise and, in so doing, help to boost the overall productivity performance of the UK economy. Summary of the key recommendations: Policymakers should address information gaps for both finance providers and small businesses, which impedes the provision of finance and in turn prevents firms from investing. Business current account data should be more accessible, with an industry-wide solution needed to improve access to credit data for those seeking to provide finance to SMEs. The Government should continue to promote alternative forms of finance and provide long-term backing for the British Business Bank. This will give it the means to promote non-bank finance and ensure there are a variety of finance options to meet the needs of businesses at different stages of their life cycle. The business tax system needs to be simplified and structured in a way that consistently encourages business investment. The Annual Investment Allowance should be set at an attractive but stable level for the long term to facilitate investment. The Government should proactively identify regions and projects where capital investment in infrastructure can deliver increases in productivity and act swiftly to deliver these projects. Improving east to west connectivity in the North of England and other regional connections will help rebalance the economy, and increase productivity in areas outside of London. 6

7 The Government must ensure that high quality broadband services are available at a reasonable price to small businesses throughout the UK. This will require far greater policy ambition to drive forward future investment in broadband infrastructure, alongside reforms to the telecoms market. Failing to embed this ambition within future infrastructure policy and delivery will result in Britain becoming increasingly uncompetitive within the global marketplace. Local Enterprise Partnerships (LEPs) should be strengthened and developed into effective agents of regional economic growth in England. The Government should improve transparency and accountability mechanisms and streamline LEP funding arrangements. LEPs should adequately consult their local small business community in the design of business support programmes, to ensure that public funds are being targeted effectively and nurturing high-performing local firms. The Government should proceed with its review into the system for applying for Research and Devlopment (R&D) tax credits; exploring options to simplify the application process and promote the scheme to thereby improve uptake among a greater number of small businesses. The Higher Education Innovation Fund should be increased to 250 million, as recommended by the Witty Review, while the option of introducing a dedicated translational funding stream to support greater collaboration between Universities and businesses should be given serious consideration. Schools and colleges should devote resources to careers education and the Ofsted inspection framework should place greater weighting on the delivery of a broad skills base across functional, workplace and interpersonal skills. The Government should target business support on boosting leadership and management capabilities in small firms. It should also support firms to undertake an annual skills audit to ascertain if they are making the best use of their workforce to meet the business s strategic aims, and identify cost-effective opportunities for training and up-skilling. The Government should establish a UK Small Business Administration (SBA) with a direct reporting line into 10 Downing Street or the Cabinet Office, to provide a strategic and coherent small business policy framework and help streamline the business support offer for small firms. To better target support, and to increase awareness of the Government schemes in place, the Government should also adopt a more commercial approach to the marketing and branding of business support. The Government should commit to an ambitious target for direct public procurement spend with small businesses in the next parliament. To complement this, the National Audit Office should publish annual performance data on spending with small, medium, and micro firms, covering all procurements over 500, for all UK public bodies. The Government should also review the impact of supply chain engagement processes on the performance and productivity of contractwinning businesses. The Government should redouble its efforts to get a greater number of small and start-up businesses exporting. UK Trade and Investment should be equipped with sufficient resource in the medium to long term to support small firms and first-time exporters. The British Business Bank should play a greater role in the provision of export finance to small and medium sized businesses, including export credit guarantees. 7

8 The UK s productivity performance: An overview Overall productivity of the UK economy 1. The UK has a long-standing productivity gap with its international competitors. Productivity as measured on an output per hour basis was 17 per cent lower than the average for the rest of the G7 in 2013, according to provisional estimates 1. This is the widest the gap has been since Similarly, output per worker was 19 per cent lower than the G7 average in Taken together, the UK has the lowest level of labour productivity in all of the G7, with the exception of Japan. 2. Output per hour in the UK fell slightly in 2013 compared to 2012, in contrast to the rest of the G7 where output per hour increased by one per cent on average. This continues a trend since 2007, where UK productivity gap with our competitors has progressively widened. 3. The UK s historic productivity lag in relation to our competitors can be explained by various factors depending on the growth accounting measure used 2. For instance, the gap with our European counterparts, such as Germany and France, is explained by levels of tangible investment or specifically the amount of capital produced per worker. By contrast, the gap with the US is primarily accounted for by differences in Total Factor Productivity, namely levels of innovation, competition, ways of working and entrepreneurship. Average skills levels both intermediate and higher - also help to explain part of the gap with Germany, France and the US. 4. The financial crisis and subsequent recession has had a severe impact on productivity growth in the UK. Although output per hour is at roughly the same level as it was prior to the recession in 2007, it is percentage points below what it would have been had pre-recession trends in productivity growth continued 3. Unlike previous recessions, the economy has not experienced a rebound in productivity growth as GDP growth began to recover, leading economists to refer to what is now commonly known as the UK s productivity puzzle. 5. A number of factors have been put forward to explain the causes of the ongoing weakness in UK productivity growth. These include the collapse of the financial sector, labour hoarding by employers during the initial phase of the downturn, the composition of the UK labour market, misallocation of capital, low levels of investment and falling real wages exacerbated by strong employment growth. Data measurement issues may also partially explain the productivity shortfall, however analysts at the Bank of England have concluded that other factors listed above are likely to be a stronger determinant 4. 1 Office for National Statistics, International Comparisons of Productivity First Estimates, HMG, Written evidence

9 Small businesses and firm level productivity 6. Small and medium-sized enterprises today account for 99.9 per cent of all businesses in the UK, 47 per cent of private sector turnover and 60 per cent of private sector jobs 5. Given their significant contribution to the economy, small businesses are by definition critical to boosting aggregate productivity levels in the UK. At the same time, dynamics within or affecting small firms may help to explain the current sluggish growth in productivity. 7. While these assumptions would appear indisputable, the literature on productivity and small businesses is relatively limited. This is in part due to a lack of detailed firm level data to allow for rigorous quantitative analysis on the productivity characteristics of small businesses. Most of the available data either involves large samples with limited information or on the other hand, detailed datasets with limited coverage among small firms In response to this, the FSB has developed a productivity indicator for the FSB quarterly Voice of Small Business Index. According to latest figures, productivity measured on this basis (turnover per employee, inflation adjusted) grew year-on-year in the second half of 2014 for the first time since comparable data began in 2010, rising by 1.1 per cent in the year to Q This is an encouraging sign for the both economy as a whole and workers in particular, as wage growth is typically linked to productivity increases. However, overall turnover per worker is still significantly lower than that seen in 2010, as the graph below demonstrates 7. Chart 1 small business productivity Small business productivity and year-on-year change (inflation adjusted turnover per employee) 97k 96k 95k 1.5% 1.0% 0.5% 94k 0.0% 93k -0.5% 92k -1.0% 91k -1.5% 90k -2.0% 89k -2.5% Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Q Inflation-adjusted turnover per worker (LHS) Year-on-year change (RHS) 5 BIS Population estimates, 2014 https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/377934/bpe_2014_ statistical_release.pdf 6 Mark Hart, Written evidence 7 FSB, Voice of Small Business Index Q4 2014, December

10 9. Notwithstanding the lack of quantitative data on small firms and productivity, a number of important insights can be gleaned from existing academic research. Firstly, start-ups can be an important source of competition, which in turn can drive productivity improvements across the economy. Through the process of creative destruction, a term coined by the economist Joseph Schumpeter, new market entrants place pressure incumbents to improve their productivity and in some cases can displace less productive firms. Schumpeter s theory proposes that over time higher rates of business churn, where less productive firms are replaced by more productive ones, lead to higher aggregate productivity levels 8. This suggests that businesses that are not subject to the same degree of competitive pressure either owing to the market or region in which they operate are likely to experience slower productivity growth or become less productive over time. 10. At the individual firm level, productivity is a good indicator of business performance and survival. It determines a firm s profitability and influences their ability to invest, innovate and compete in markets both at home and oversees. The productivity of a firm also has an impact on its growth potential. 11. Evidence from NESTA 9 suggests that firms that exhibit high total factor productivity are more likely to experience high growth in sales. So called high growth firms account for less than one per cent of the business population, yet they created 36 per cent of new net jobs between 2008 and Many of these firms are small or medium sized businesses, or at least started off as small firms. According to Mark Hart at Aston Business School, high growth is a self-reinforcing process where more productive firms are more likely to achieve high growth status and in turn high growth firms are more likely to achieve higher productivity growth Not all businesses will achieve high sales or productivity growth. In the short term, start-ups are unlikely to be operating at their full potential productive capacity. Evidence from the US suggests that productivity levels converge between different age cohorts of business after five to ten years time, but productivity in the early stages of business formation is weak compared to established firms Furthermore, the rate of start-ups in the UK does not appear to have a tangible impact on productivity levels. The rate of start-ups has remained steady since the downturn averaging just over 400,000 per year 13 at a time when productivity growth has fallen. At the same time we have seen a surge in self-employment which now accounts for 15 per cent of the labour force, up from 13 per cent since the start of the recession. While much of the recent growth in self-employment may signal a burgeoning of new entrepreneurial activity, it may not necessarily translate into higher levels of productivity. Indeed, the Monetary Policy Committee of the Bank of England has suggested that it is inclined to believe that a least some of the self-employed are underemployed and not using their full productive potential, which may have a bearing on aggregate productivity levels See also HMG, Written evidence ERC, Written evidence 11 Ibid 12 Jensen, J., McGuckin, R. and Stiroh,K., The impact of vinatge and survival on productivity: Evidence from cohorts of US manufactoring plants, May Banksearch / HMG, Written evidence 14 April 2014 minutes 10

11 14. Productivity also varies significantly by sector in the UK. Output per worker is higher in sectors such as telecommunications compared with food services and accommodation. This may be explained by comparative skill levels of workers, with the former typically associated with higher skilled work than the latter. However, the evidence suggests that the UK s productivity gap with other countries owes more to poor productivity performance within sectors, rather than the sectoral mix of the economy According to Government estimates 16, the top 10 per cent of manufacturing businesses are more than five times as productive as the bottom 10 per cent a trend that is similar, although less prominent, in other countries such as the US. It has been suggested that this is a result of a misallocation of resources to lower productive businesses and possibly a slower pace of reallocation to higher productive business through levels of competition and other external influences. 16. Lastly, Government policy and regulations impact upon a firm s ability to grow, invest and improve its productive capacity. The Government s joint submission to this inquiry points out that high levels of productivity in the US may be linked to the size of the economy and the ability of US firms to access a very large single market relatively unhindered 17. Similarly labour or product market regulations can effect business growth and therefore productivity, for instance regulatory thresholds or exemptions according to business size can artificially restrict business growth Government policy is also critical in shaping the business environment, in areas such as the availability of finance, the effectiveness of business support, skills provision and access to infrastructure. All can affect on a firm s ability to do business and ultimately boost their performance. These areas form the focus of the remainder of this inquiry. 15 HMG, Written evidence 16 ibid 17 While there are differences in regulatory regimes between US states, they do not appear to pose significant barriers to market access across the US. HMG, Written evidence. 18 See for instance, Garicano, L., LeLarge, C. and Van Reenen, J. (2012), Firm Size Distortions and the Productivity Distribution: Evidence from France, Centre for Economic Performance discussion paper No

12 Drivers of small firm productivity: Access to finance and business investment 1. There is widespread evidence showing that business investment is an important driver of productivity. It was one the five drivers of productivity set out by the Labour Government in 1997, with much analysis and policy action undertaken to raise the UK s performance on investment. 2. Efforts to raise investment have remained a central policy objective of successive governments, though the focus has not always been on smaller companies. Despite those efforts, on a business investment to GDP ratio (measured by gross capital formation), the UK continues to perform poorly compared to other OECD countries. In the context of this inquiry, it is worth noting Eurostat figures which show UK SMEs only contributed 38 per cent of total tangible business investment in 2012, a lower share than other EU countries While UK firms tend to perform better on measures of intangible investment, such as in software and organisational change 20, our historical weakness on tangible investment which has continued since the recession remains a cause for concern. 4. The underlying causes behind this relative underperformance of UK firms are widely documented and will not be repeated here. This chapter instead focuses on the link specifically between access to finance and investment, where further measures could be taken to raise performance. It also notes the tax environment as important though this did not feature prominently in the evidence put to the inquiry. It is nonetheless widely considered to be an important aspect to incentivising both investment by firms, and to attracting investment from outside investors into firms with promising growth prospects. Access to finance 5. The ability to obtain finance, and of the right type for their stage in the lifecycle, often determines whether or not a firm will grow. Since capital is needed to fund investment, it is also a precondition for business investment, and therefore for individual firms ability to expand and raise their productivity. By the same token, a lack of access to external finance can constrain cash flow and ultimately hamper businesses investment and survival prospects. 6. In this context, the FSB among others has noted the important role of payment practices and the growing issue of late payments, particularly by large companies towards their suppliers. This can have a significant impact on affected firms in terms of their profitability, as well as their ability to plan and invest. 19 European Commission (2014) Annual Report on European SMEs (Database for the Annual report) policies/sme/facts-figures-analysis/performance-review/files/supporting-documents/2014/annual_report_database.zip 20 See for instance Goodridge, Wallis and Haskell 2014, investment_in_intangible_assets_report_for_nesta.pdf 12

13 7. Late payment harms cash flow, which in turn inhibits investment in capital and resources. Research from Bacs confirms that the debt of overdue invoices for SMEs now stands at approximately 32.4 billion 21. Furthermore, it is estimated that the average business with less than 250 employees is currently owed around 32,000 in unpaid bills. Action to address this issue must be a priority for the Government 22. Essentially, late payment amounts to de facto capital held by larger firms to invest in their own activities to the detriment of their suppliers. It can also delay payments through the supply chain to the detriment of other firms. The inquiry committee recognises the measures in the Small Business, Enterprise and Employment Bill to address late payments, but more needs to be done. The current imbalance of power that exists in the relationship between creditors and debtors needs to be addressed, with small firms being given a clear legal justification if they decided to seek redress or reject unfair payment terms. 8. Looking at finance from external sources, evidence shows that only 15 per cent of small businesses are currently seeking or have used external finance in the past year. Around 60 per cent of smaller businesses do not use formal sources of external finance, instead relying on trade credit from their suppliers or retained earnings Of those that do seek external finance, debt finance continues to dominate. Equity finance is far less common with only around one per cent of SMEs using this type of funding. Similarly, the proportion of SMEs obtaining finance from peer to peer lending platforms and crowdsourcing is currently very low at less than one per cent each. This is in part due to the recent arrival of these providers into the market and therefore low awareness among firms of their services. 10. Lack of awareness of alternative funding options when compared with bank finance has been identified by a number of studies, including Government commissioned research 24. As a result of this, some SME customers make alternative arrangements such as reappraising cash-flow requirements, using other credit lines (including personal loans and credit cards) or placing greater reliance on credit from suppliers. 11. Evidence provided to the inquiry from ICAEW, HSBC, Lloyds, and Funding Circle made regular reference to improving the ability of firms to identify a diverse range of external sources of finance other than the bank that provides their business current accounts. While alternative finance providers and platforms have grown in size and significance in the UK, facilitating 939 million in funding to individuals and businesses in 2013, this represents a very small proportion of the overall market A number of solutions have been put forward to increase the range of providers used by businesses, including making switching between providers easier, and putting in place a referral mechanism to guide firms to other providers should their initial finance application be declined. Funding Circle data shows that 50 per cent of businesses exploring finance with their bank do not reach the formal application stage, 61 per cent do not get to the formal rejection stage, and only 12 per cent receive a rejection letter from the bank 26. Small businesses therefore need to be 21 Bacs news release, February Available at: businesses_to_make_tough_decisions.pdf 22 Ibid 23 BDRC Continental (2014) SME Finance Monitor Q aspx?alid= `See for instance BIS, SME journey towards raising external finance, Oct uploads/2013/10/sme-journey-towards-raising-finance.pdf 25 Nesta, The rise of future finance, Dec Funding Circle, Written evidence 13

14 signposted to alternative lenders before the point of rejection. This would help to increase SME access to alternative finance options and enhance lending volumes. 13. In addition, HSBC suggested the lack of access to the VAT register makes assessing the risk of funding applications more difficult for finance providers. The consequence of that lack of information is that creditworthy businesses often struggle to access finance, while firms with poor credit records access funding. 14. Efforts are now being made by the Government and the industry to address these issues. These should continue, starting with granting access with appropriate safeguards to the VAT register by the credit rating agencies (CRAs) as well as measures to improve the transparency of the credit scoring process. Furthermore, the current seven day switching service for firms moving banks could be improved further, alongside a referrals mechanism which would also help to match businesses to alternative lenders and promote competition in the market. In a further effort to improve information and to match investors to firms with growth potential, Sherry Coutu 27 has suggested national data sets should be made available so that local public and private sector organisations can identify, target and evaluate their support to scale-up companies. 15. Improving information flows and helping lenders identify companies who might make use of finance more effectively will have two particularly important benefits for investment and ultimately productivity: First, it should improve allocative efficiency namely that resources are better allocated across the economy to more productive ends thereby increasing growth. Firms who are creditworthy and who have better survival and growth prospects should therefore have access to appropriate sources of finance. In that regard, recent modelling by HMRC 28 has shown the potential benefits of access to the VAT register by the CRAs. Firms are more likely to be directed to providers who best match their needs. As set out below, this may go beyond purely financing requirements. Different external providers, and particularly equity investors, can bring significant expertise and knowledge that can produce significant growth dividends for the firm. However, as well as identifying providers, measures are required to address funding gaps for ambitious businesses that may explain part of the relatively weak investment performance by UK firms. 27 The scale-up report on UK economic growth (November 2014) 28 Report on use of non-financial VAT registration data in trade credit scoring (HMRC 2014) https://www.gov.uk/government/uploads/ system/uploads/attachment_data/file/323121/non-financial_vat_registration_data_research_project_report.pdf 14

15 Incentivising business investment through the tax system 16. Tax plays an important role in encouraging investment by firms. Concerns have been raised, especially from larger companies, on the link between investment in plant and machinery and business rates. Firms have reported that the benefits of investing in upgrading their plant and machinery are eroded by the consequential increase in business rates. As many have argued, the business rates system needs reform and the Government has now committed to reviewing the system, and will be reporting back in The Annual Investment Allowance (AIA) was temporarily increased to 500,000 at Budget 2014, a welcome 20-fold increase from 2011 when it stood at 25,000. This welcome step should incentivise greater levels of business investment. However the increase is temporary and due to end on 31st December Rather than regularly altering the rate, a high and, importantly, stable rate is needed to give firms certainty and allow them to plan their investments over a longer period. 18. Evidence from the Government to this inquiry highlighted the importance of investing in R&D. As chapter 5 outlines, R&D investment in the UK, both in the public and private sectors, has historically compared poorly with the UK s international competitors. Incentives have been provided to smaller firms to invest in R&D through tax credits, and were recently raised to 230 per cent of investment in the Autumn Statement However, firms have concerns about accessing the R&D tax credit, both in terms of its complexity and the exclusions from making a claim. In a recent survey, the FSB found that just one in fifty of its members had claimed the credit, with a tenth saying they had not claimed due to the complexity of the process 29. A review into the application process that started in January 2015 was announced at Autumn Statement It will be important to see progress made in simplifying the system if a resulting uptake of tax credits is to occur. 19. On a broader note, the overall complexity of the business tax system can often deter productive investment by businesses. The Association of Independent Professionals and the Self Employed (IPSE) argued in its submission that one of the biggest drags on freelancer productivity is the tax system 30. Similarly, the FSB has reported that the average small business spends over 3,600 a year complying with their tax obligations through accountants 31, payroll and tax software. As has been recognised by others, the current tax system needs to be simplified and structured in a way that consistently encourages rather than deters business investment. 29 FSB, Voice of Small Business Survey Q1 2014, May IPSE, Written evidence 31 FSB, Voice of Small Business Survey Q3 2013, September

16 Alternative sources of finance 20. As noted earlier, evidence shows that most firms do not seek external finance. Of those that do, equity finance is rarely used with debt finance more appropriate. But as the Breedon review 32 indentified, equity, along with alternative channels for debt capital, can potentially benefit these businesses in the early stages of their development. While not the focus of his review, Breedon highlighted the importance of getting the right framework to stimulate investor appetite for equity and to lower the cost of raising such capital. 21. Some progress has been made to stimulate investor demand in equity. In their evidence, Lloyds highlighted the equity investments made by the Business Growth Fund (BGF), a fund worth around 2 billion established by the large banks at the time of the crash to invest in UK companies. BGF takes equity stakes typically valued at between 2-10 million in companies it sees as having credible growth plans. A particular feature is that these investments are usually for at least five years the patient capital many commentators view as lacking in the UK. 22. The Government can also encourage external investors to invest in start-ups and small firms. The recent introduction of the Seed Enterprise Investment Scheme (SEIS), which dovetails with the Enterprise Investment Scheme established in 1994, provides both income tax and capital gains tax relief to investors who subscribe for shares in qualifying companies. The scheme is aimed primarily at early-stage start-ups, reflecting the particular challenges these firms face in raising capital. Indications are that the scheme is having some success, with the levels of equity investments and activity at seed scale rising from previous years. As such the scheme should be continued to provide certainty for investors and for the market to develop. 23. On the supply-side, the creation of the British Business Bank has added a further source of liquidity to the market, and has begun to address well-recognised market failures that have resulted in persistent gaps in the funding escalator, from seed funding through to more sophisticated venture capital funds. Assessing the investment risk in younger businesses, especially those operating in new markets or developing new technologies, is difficult. Investor appetite is therefore either limited or investment is offered on terms that the firm cannot meet. The effect is this lack of access to finance impacts on longer-term growth. The Government, through the BBB, can address these market failures by accepting low rates of return and higher risk, and thereby increase the supply of this risk capital to firms who offer significant growth upsides. 24. In the private sector, arguments have been put forward to encourage investments in peer-topeer platforms to further increase the supply of capital and diversify the market. In that respect, the consultation on ISA wrappers for peer-to-peer lenders is to be welcomed as is changing the treatment of bad debt for investments in peer-to-peer lenders announced in the Autumn Statement This was an aspect of the tax system that Funding Circle argued needed reform in their submission to the inquiry. 32 Boosting finance options for business March,

17 25. In addition to providing capital, equity investors can also bring significant external expertise to a firm which in turn can boost their growth prospects and performance. This contrasts with debt finance, where lenders tend to take a more passive approach. Access to such expertise is important given the widespread evidence 33 of relatively poor leadership and management capabilities within firms, which has been identified as a key factor lying behind the UK s weak productivity performance, as well as profitability and survival rates. Lord Heseltine 34 highlighted this point in his 2012 report No stone unturned: in pursuit of growth, noting that limited leadership and management capacity among UK firms was a feature of the Competitiveness Reviews carried out by the Government in the 1990s and yet continued to persist well over a decade later. 26. Addressing this management capacity weakness among smaller firms, where individuals can have a bigger impact on firm performance compared to larger firms where impact can be diluted, remains an under-recognised issue. Improved managerial capabilities should also mean firms are more likely to attract the confidence of external investors. Unless it is believed that as a rule entrepreneurs are born and not made, and born with the management talents to grow businesses, ongoing efforts to develop these skills in the UK workforce will be needed. 27. This issue is explored in more detail in chapters 6 and 7, where the role and effectiveness of Government business support in raising capabilities in these and other areas is considered. The conclusion here however is that if equity finance can introduce greater management capabilities into firms, there should be benefits to promoting equity finance for reasons beyond boosting access to capital and diversifying sources of finance available to small businesses. 33 See for instance, Bloom, Nick and Van Reenen, John (2010) Human resource management and productivity In: Ashenfelter, Orley and Card, David, (eds.) Handbook of Labor Economics 34 Lord Heseltine, No stone unturned: in pursuit of growth (2012) 17

18 Recommendations Policymakers should address information gaps for both finance providers and businesses, which impedes the provision of finance and prevents firms from investing. Business current account data held by closed user groups within credit reference agencies should be opened up and support given to HM Treasury s proposals on the sharing of credit data to find an industry-wide solution to improved access to credit data for those seeking to provide finance to SMEs. The Government should develop a more comprehensive SME lending dataset that builds on the Bank of England s existing data sets, to get a more accurate picture of the SME financing landscape by firm size. This should seek to understand the reasons why 78 per cent of SMEs are classified as happy non-seekers of finance and 85 per cent of SMEs are not approaching a bank to apply for credit. In addition, awareness of the lending appeals process should be raised among SMEs. The Government should continue to promote alternative forms of finance and provide longterm backing for the British Business Bank so it has the means to promote alternative sources of finance and ensure there are a variety of finance options to better meet the needs of businesses at different stages of their life cycle. Equity finance is a crucial enabler of high-growth businesses and should be promoted. There could be an educational role for the British Business Bank to assist more businesses to become investment ready and attract equity investors. Policymakers should continue to develop and refine the EIS and SEIS schemes, and look at means to raise the overall level of equity investments in start-ups and firms in the early stages of their growth plans. Equity investors can bring management and other expertise into firms, and these opportunities should be maximised. To continue to increase competition and diversity of choice, policymakers should reduce barriers to entry by ensuring alternative finance providers are not at a competitive disadvantage relative to high street banks. This includes mandating signposting to alternative finance providers before the formal rejection stage and ensuring that supervisory and regulatory measures are proportionate. The business tax system needs to be simplified and structured in a way that consistently encourages business investment. The aim should be for the AIA to be set at an attractive but stable level for the long term to facilitate investment and provide certainty for businesses planning their growth strategies. The Government should tackle late payment practices by larger companies by enforcing a prompt payment limit of 60 days and strive for 30 days as good practice. 18

19 Connecting markets: Infrastructure and regional development 1. Businesses require modern infrastructure to connect with customers and suppliers, and secure new business opportunities. As the joint Government submission to this inquiry states, infrastructure is vital to any modern economy. It drives growth, creates jobs and generates the networks which allow businesses and organisations to grow 35. It is therefore a pre-condition for business performance, growth and in some cases survival. 2. An absence of modern infrastructure capabilities, including high-quality transport networks and telecommunication services, makes it harder for firms to innovate and improve their productivity. The need for well-functioning infrastructure is well evidenced in existing research, including from the World Bank, which finds that infrastructure is a key ingredient for productivity and growth. 3. Economic geography can also have a significant impact on productivity. London and the South East benefit from economic and productivity benefits owing to the concentrated density of the region. In contrast, areas like Cornwall view the geographic feature of their region as a key fact of economic life The link between economic geography and infrastructure investment is well evidenced. Previous studies have identified significant disparities in the level of investment in infrastructure across the UK, with London and the South East receiving disproportionately large per capita investment compared to the rest of the UK. An IPPR North report found that per capita spending in London on transport projects was almost 2,600 per annum. By contrast, the figure was just 5.01 per annum for the North East. Outside the South East, the highest level of per capita spending was in the East Midlands at per capita. However, this figure still amounts to less than 10 per cent of per capita spending on infrastructure in London Disparities in infrastructure investment have unsurprisingly meant different levels of infrastructure capacity across the country. This is likely to have had an impact on the realisable productivity within a given region. In its evidence to this inquiry, the university think-tank Million+ highlighted evidence that the UK had the widest disparity in productivity between its regions than any other country in the European Union Similarly, a recent report from the RSA s City Growth Commission found significant variation in the level of per capita gross value added both across the UK and within regions (see chart 2). This is backed up by evidence submitted to this inquiry by the York, North Yorkshire and East Riding LEP, which demonstrated the significant variation in productivity levels within the region they represent 39. The RSA estimated that improving regional connectivity and broadband access, along with devolving political power to cities, could yield a five per cent growth in productivity HMG, Written evidence 36 Cornwall and Isles of Scilly LEP, Written evidence 37 IPPR North, Still on the wrong track: An updated analysis of transport infrastructure spending. images/media/files/publication/2013/06/still-on-the-wrong-track_june2013_10933.pdf 38 Eurostat data. Available at: 39 York, North Yorkshire and East Riding LEP, Written evidence 40 RSA City Growth Commission: Unleashing Metro Growth. data/assets/pdf_file/0009/ /final-report- Unleashing-Metro-Growth.pdf 19

20 7. Of note, and not reflected in this chart, is the extent of the difference in per capita GVA in London and the rest of the UK. Inner London (West) produced an average per capita GVA of 127,127, which is far in excess of any other region 41. Variation within regions in economic value produced per person, 2012 Northumberland 12,049 North East 20,163 Darlington Wirral 11,599 North West 25,947 Warrington Barnsley, Doncaster & Rotherham 13,050 Yorkshire & Humber 24,770 Leeds South Nottinghamshire 13,120 Dudley 12,608 East Midlands West Midlands 23,537 Solihull 26,748 Nottingham Southend-on-Sea 15,406 East of England 24,155 Hertfordshire Isle of Wight 14,023 South East 34,978 Berkshire Cornwall and Isles of Scilly 13,036 South West 27,200 Swindon Isle of Anglesey 10,364 Wales 21,239 Cardiff & Vale of Glamorgan North of Northern Ireland 12,382 Northern Ireland 32,737 Belfast 0 5,000 10,000 15,000 20,000 25,000 30,000 35,000 40,000 Note: Within Greater London, GVA ranges from 13,928 in Outer London (E&NE) to 127,127 in Inner London (West) Source: RSA City Growth Commission 8. Evidence provided by Million + backs up the finding of the RSA report, and shows that there has been an increase in this regional gap in GVA over the period It also demonstrated the extent to which London continues to dominate in share of national GVA Rebalancing investment in infrastructure and thereby allowing businesses to connect to larger markets and suppliers beyond their immediate locale - can help to unlock the productivity and growth potential of businesses across the UK, and boost GVA both within and between regions. In contrast, constraints on infrastructure provision can deter inward investment and job creation. If areas outside of London and the South East are to begin to match the productivity of those regions, a significant rebalancing of infrastructure spending across all transport modes is required. 10. The Government has taken steps to address this through its latest National Infrastructure Plan. However, funding for infrastructure is still weighted towards London and the South East. Future regional infrastructure projects must be planned well in advance to ensure that sufficient skilled labour is available and that local firms can benefit from regional infrastructure spending for instance, in being able to access procurement opportunities throughout the supply chain RSA City Growth Commission: Unleashing Metro Growth data/assets/pdf_file/0009/ /final-report- Unleashing-Metro-Growth.pdf 42 Million +, Written submission 43 National Infrastructure Plan https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/293688/ PU1656_Infrastructure_Finance_Update.pdf 20

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